Reimagining Uniswap LP Positions with Panoptic
Uniswap was established in 2018 on the Ethereum blockchain. It was not the first decentralized exchange (DEX) but it quickly became the most prominent. Uniswap has staying power as a DeFi blue-chip. The protocol has been able to attract over $3 billion in TVL, and is consistently doing over $1 billion in volume daily.
On Uniswap anyone can create a market for a token, without having to pay large listing fees associated with centralized exchanges (CEX). As long as there is liquidity for the trading pair, you have a Uniswap market to trade your crypto! But where does that liquidity come from and how does this system work?
How does Uniswap LP’ing Work
Providing liquidity to a Uniswap pool is so simple, anyone with a self custody wallet can do it. But beware, if you don’t truly understand what is happening under the hood, you may suffer losses.
Uniswap is not a typical order book, where the mid-market rate of two assets is determined by the highest buyer and the lowest seller. It uses an automated market maker (AMM) to determine price. AMM’s provide a price to traders based on the supply and demand of the two assets in the liquidity pool. This alternative approach to adjusting asset prices based on supply and demand employs a well-established mathematical equation. It functions by raising or lowering the price of a token according to the ratio of tokens present within the associated pool. The formula for determining the price of each token is x*y=k, where the amount of token A is x and the amount of token B is y. K is a constant value.
For instance, let’s consider Bob who aims to exchange AAVE for ETH within the Uniswap AAVE/ETH pool. Bob contributes a substantial quantity of AAVE to the pool, causing the AAVE-to-ETH ratio in the pool to rise. As the value of k must remain constant, this adjustment results in an increase in ETH’s cost while causing the cost of AAVE in the pool to decrease. Consequently, the greater the amount of AAVE that Bob sell, the fewer ETH he receives in return due to the heightened price of ETH.
But where is that AAVE and ETH coming from? Liquidity providers!
When providing liquidity to a pool on Uniswap, you must deposit an equal amount (in value) of each asset. The more liquidity in a pool, the less slippage traders will encounter when making sizeable trades. Liquidity providers are incentivized to deposit their assets so that they can earn a portion of the trading fees. Usually fees are set at 0.3%. Because certain trading pairs can see millions in volume per day, these trading fees add up, and Uniswap LPs can earn more tokens for providing this service.
Impermanent Loss and Other Factors
To say that becoming a Uniswap LP is entirely sunshine and rainbows would be misleading. Sophisticated DeFi users know about impermanent loss (IL) and you should to!
To avoid over complicating things, IL can be boiled down to the following: LPs are entitled to their % of the assets in the pool, not the amount of assets they originally deposited. Let’s go over an example.
Bob deposits 20 ETH and 20,000 USDT to the ETH-USDT pool on Uniswap. The price of ETH is $1000. At the time of deposit, the total value of the pool is $200,000. Since Bob deposited $40,000 worth of tokens, he receives an LP token that is worth 20% of the assets in the pool. 1 month later, the price of ETH is now $2000. Lets do a little math. Prior the price adjustment, there were 100 ETH and 100,000 USDT in the liquidity pool. If we use our formula (100*100,000=k) we get a constant for k that equals 10,000,000. To find the new weighting of ETH in the pool based off the price change, we take the square root of (k / new ETH price) and to find the new weighting of USDT in the pool we take the square root of (k * new ETH price). Punch that into your calculator and you will get 70.71 ETH and 141,421 USDT. Bob’s 20% of the pool amounts to 14.14 ETH and 28,284 USDT. With the ETH price now at $2000, the value of Bob’s LP position is now $56,568. However, had Bob just held his original 20 ETH and 20,000 USDT, he would have had $60,000.
It is important for Uniswap LPs to manage their positions closely. The least downside comes from a trading pair experiencing very little volatility. Impermanent loss isn’t the only thing LPs have to worry about. They must also worry about: 1) Loss-versus-rebalancing (the difference between rebalancing your LP versus passive LP’ing) & 2) Just-in-time liquidity (LPs adding concentrated liquidity in a tight range extremely quickly and taking the majority of the fee). Unfortunately the average Uniswap LP may not understand all of this. But what if there was another way to look at providing liquidity to Uniswap?
Uniswap LP’ing or Selling an Option?
Uniswap v3's updated approach (concentrated liquidity) unintentionally results in liquidity positions that closely resemble the outcomes of two specific option strategies: cash-secured puts (where a put option is sold while cash is reserved to purchase the underlying asset at the predetermined strike price) and covered calls (entailing the sale of a call option on an already-owned underlying asset). Due to the principle of put-call parity, these two positions exhibit identical payoff diagrams.
As these outcomes originate from liquidity pools via LP tokens, there are several distinctions from conventional options. To begin with, these options lack expiration dates, and the underlying assets undergo automatic conversion through trading actions. Moreover, the valuation of a typical option, including the premiums earned by a seller, can be determined using the Black–Scholes model. In brief, the price hinges on the existing spot price, the time left until expiration, and the implied volatility (IV). Conversely, a Uniswap liquidity provider (LP) gains trading fees from the underlying liquidity pool.
These fees share a connection with option premiums.
Liquidity providers (LPs) generate fees when the spot price enters the range they have designated. In cases where the range consists of just one tick, it can be inferred that the price is unlikely to remain within this single-tick range for an extended period. Consequently, the premiums can be attributed to two primary elements:
- The frequency at which the price crosses the single tick range.
- The fee rate associated with the underlying pool.
Essentially, there is no limit on the premium you can earn through a Uniswap v3 LP position. Because of this, the Black–Scholes model break down since the concept of expiration does not exist.
Enter Center Stage: Panoptic
Now we know, participating in a Uniswap v3 pool as a liquidity provider is comparable to engaging in an option shorting strategy. It would also then be true that reversing this liquidity position creates a theoretical long-option payoff. Nevertheless, establishing a lending structure from an LP position is unfeasible due to the non-fungible nature of each Uniswap position.
This is why Panoptic was born! This protocol facilitates payoffs similar to options by transferring liquidity between participants within the ecosystem while earning a commission fee for facilitating these transactions. When a Uniswap v3 pool exists for a token pair, Panoptic can establish an options market for that particular pair. This stands in stark contrast to centralized exchanges and previous options protocols that only offer options for a limited number of tokens.
The Panoptic ecosystem consists of three participants: liquidity providers, who earn yield from lending their capital to options sellers; option sellers, who provide collateral and borrow capital from LPs to create short options by concentrating liquidity within Uniswap v3 pools; and option buyers, who provide collateral to cover potential premiums for sellers and remove capital deployed to Uniswap v3 pools by option writers, thereby creating long positions.
By segregating LPs and option sellers, Panoptic has establishes distinct roles with clearly defined risks and returns tailored to various market participants. This enhances capital efficiency, and the availability of opportunities across all investors. Participants within the Panoptic ecosystem can withdraw their funds whenever sufficient capital is present. Additionally, beyond earning premiums on written options akin to Uniswap LP fees, sellers also accrue yield on their collateral. Option buyers can leverage their positions and pay similar premiums as they would for a Black–Scholes priced option on average, but with greater flexibility in their positions.
Oh, and did I mention that Panoptic allows for perpetual options instead of traditional expireable options? A notable advantage of creating perpetual options using LP tokens is that liquidity remains consolidated. In this system there are no fixed expiration dates or pre-specified premiums that exist. Therefore all option writers for the same token pair sell identical option contracts across strike prices. This ensures that Panoptic can effectively function as a virtual liquidity manager for Uniswap v3 positions.
Because of this new approach to on-chain options, buyers and sellers are always helping to restructure liquidity at different price points. Since there is very little liquidity for on-chain options, this design proves highly advantageous for traders looking to buy/sell options beyond the few underlying ones that exist today. In this manner, Panoptic serves to greatly enhance the adoption of on-chain options by making them more dependable and readily available for your average DeFi user!
